Meaning of Production

In popular language, the term production is

used to mean creation of a new
commodity or a service. In economics,
production means creation of new utility.
 Production Function
A production function is a technical relationship between
the inputs of production and output of the firm; the
relationship is such that the level of output depends on
the levels of inputs used, not vice versa. A production
function is traditionally expressed by the following
equation:
q = f(K,L)
Where,
Q = the level of output
f = the symbol of relationship, which is determined by the
production engineers.
K = the amount of capital
L = the amount of labour
 Production Function
A production function may be a short run or a long run
production function depending on the period of time. In a
short run production function, at least one input of
production cannot be changed.
In a long run production function, all inputs of production
can be changed.
Short run does not specify a specific period of time; it
depends on the nature of the commodity in question. It
may be six months for one commodity and one year for
another commodity, etc.
The inputs of production consists of raw materials that a
particular firm buys to use in the production process and
the inputs may be the commodities produced by other
firms.
Production Function
 Production Function
 States the relationship between inputs and outputs
 Inputs – the factors of production classified as:
 Land – all natural resources of the earth
 Price paid to acquire land = Rent
 Labour – all physical and mental human effort involved in
production
 Price paid to labour = Wages
 Capital – buildings, machinery and equipment
not used for its own sake but for the contribution
it makes to production
 Price paid for capital = Interest
 Production Function

Inputs Process Output

Land
Product or
Labour service
generated
– value added
Capital
 Analysis of Production Function:
Short Run
 In the short run at least one factor fixed in supply but all other
factors capable of being changed
 Reflects ways in which firms respond to changes
in output (demand)
 Can increase or decrease output using more or less of some
factors but some likely to be easier to change than others
 Increase in total capacity only possible in the long run
Analysis of Production Function:
Short Run
In times of rising
sales (demand)
firms can increase
labour and capital
but only up to a
certain level – they
will be limited by
the amount of
space. In this
example, land is
the fixed factor
which cannot be
altered in the short
run.
Analysis of Production Function:
Short Run
If demand slows
down, the firm can
reduce its variable
factors – in this
example it reduces
its labour and
capital but again,
land is the factor
which stays fixed.
Analysis of Production Function:
Short Run
If demand slows
down, the firm can
reduce its variable
factors – in this
example, it
reduces its labour
and capital but
again, land is the
factor which stays
fixed.
 Law of Variable Proportions
Depending on the nature of the product curves, the
economists have divided the diagram into three parts
on the basis of quantity of labor used in the production
process. These three region are O-L2, L2-L3,L3-infinite.

The first region is called the region of increasing returns,

because marginal productivity of the variable input
increases here. The producer will not stop here.

The second region, L2-L3, is known as the region of

diminishing returns, because marginal productivity
diminishes in this region. The entrepreneurs find that
increased doses of labor applied to a fixed quantity of
other inputs result in decreasing amount of marginal
products. Like agricultural production function.
 Law of Variable Proportions
The second stage is also called the economic stage,
because the entrepreneur produces at some point in this
stage.
The point of production, of course, depends
on the prices of the two inputs, the variable
input and the fixed input.
Foe example, the producer will produce at OL2 if the fixed
input is free but the variable input is not free. Similarly,
the producer will produce at OL3 if the variable input is
free but the fixed input is not free.
She/He will produce at some point in the second stage if
both the inputs are not free.
 Law of Variable Proportions
The third stage is called the stage of negative
returns. The producer will not produce in this
stage, because the marginal product of the
variable input is negative here. In this case, the
producer can increase her/his total product by
withdrawing labor from production process.
Some economists call this stage of disguised
stage.
 Analysing the Production
Function: Long Run
 The long run is defined as the period of time taken to vary all factors of
production
 By doing this, the firm is able to increase its total capacity – not
just short term capacity
 Associated with a change in the scale of production
 The period of time varies according to the firm
and the industry
 In electricity supply, the time taken to build new capacity could be
many years; for a market stall holder, the „long run‟ could be as little
as a few weeks or months!
 Analysis of Production Function:
Long Run

In the long run, the firm can change all its factors of production thus
increasing its total capacity. In this example it has doubled its capacity.
Step Capital Labor Capital-Labor Total
K L ratio Output
K/L
1 10 20 10/20= ½ 100

2 20 40 20/40= ½ 300

3 40 80 40/80= ½ 600

4 80 160 80/160= ½ 1000

 Production Function
 Mathematical representation
of the relationship:
 Q = f (K, L, La)
 Output (Q) is dependent upon the amount
of capital (K), Land (L) and Labour (La)
used
Costs
 Costs

 In buying factor inputs, the firm

will incur costs
 Costs are classified as:
 Fixed costs – costs that are not related directly to
production – rent, rates, insurance costs, admin
costs. They can change but not in relation to
output
 Variable Costs – costs directly related
to variations in output. Raw materials primarily
 Costs
 Total Cost - the sum of all costs incurred in
production
 TC = FC + VC
 Average Cost – the cost per unit
of output
 AC = TC/Output
 Marginal Cost – the cost of one more or one
fewer units of production
 MC = TCn – TCn-1 units
 Costs
 Short run – Diminishing marginal returns
results from adding successive quantities
of variable factors to a fixed factor
 Long run – Increases in capacity can lead
to increasing, decreasing or constant
returns to scale
 Production Function

 The firm‟s production function for a

particular good (q) shows the maximum
amount of the good that can be
produced using alternative
combinations of capital (K) and labor
(L)

q = f(K,L)
 Marginal Physical Product
 To study variation in a single input, we
define marginal physical product as the
additional output that can be produced
by employing one more unit of that input
while holding other inputs constant
q
marginal physical product of capital  MPK   fK
K
q
marginal physical product of labor  MPL   fL
L
 Diminishing Marginal
Productivity
 The marginal physical product of an
input depends on how much of that input
is used
 In general, we assume diminishing
marginal productivity
MPK  2q
  fKK  0
K K
MPL  2q
  fLL  0
L L
 Diminishing Marginal
Productivity
 Because of diminishing marginal
productivity, 19th century economist
Thomas Malthus worried about the effect
of population growth on labor productivity
 But changes in the marginal productivity
of labor over time also depend on
changes in other inputs such as capital.
 Average Physical Product
 Labor productivity is often measured by
average productivity

output q f (K , L )
APL   
labor input L L

 Note that APL also depends on the

amount of capital employed
A Two-Input Production Function
 Suppose the production function for
flyswatters can be represented by
q = f(K,L) = 600K 2L2 - K 3L3
 To construct MPL and APL, we must
assume a value for K
 Let K = 10
 The production function becomes
q = 60,000L2 - 1000L3
A Two-Input Production Function
 The marginal productivity function is
MPL = q/L = 120,000L - 3000L2
which diminishes as L increases
 This implies that q has a maximum
value:
120,000L - 3000L2 = 0
40L = L2
L = 40
 Labor input beyond L=40 reduces output
A Two-Input Production Function

 To find average productivity, we hold

K=10 and solve
APL = q/L = 60,000L - 1000L2
 APL reaches its maximum where
APL/L = 60,000 - 2000L = 0
L = 30
A Two-Input Production Function

 In fact, when L=30, both APL and MPL

are equal to 900,000

 Thus, when APL is at its maximum, APL

and MPL are equal
 Isoquant Maps
 To illustrate the possible substitution
of one input for another, we use an
isoquant map
 An isoquant shows those
combinations of K and L that can
produce a given level of output (q0)

f(K,L) = q0
 Isoquant Map
 Each isoquant represents a different level
of output
 output rises as we move northeast
K per period

q = 30
q = 20

L per period
 Marginal Rate of Technical
Substitution (MRTS)
 The slope of an isoquant shows the rate
at which L can be substituted for K
K per period
- slope = marginal rate of technical
substitution (MRTS)

MRTS > 0 and is diminishing for

A
KA increasing inputs of labor
B
KB
q = 20

L per period
LA LB
 Returns to Scale
 How does output respond to increases in
all inputs together?
 Suppose that all inputs are doubled, would
output double?
 Returns to scale have been of interest to
economists since the days of Adam Smith
 Returns to Scale
 Smith identified two forces that come into
operation as inputs are doubled
 greater division of labor and specialization of
labor
 loss in efficiency because management may
become more difficult given the larger scale of
the firm
 Returns to Scale
 If the production function is given by q =
f(K,L) and all inputs are multiplied by the
same positive constant (m > 1), then
Effect on Output Returns to Scale
f(mK,mL) = mf(K,L) Constant
f(mK,mL) < mf(K,L) Decreasing
f(mK,mL) > mf(K,L) Increasing
 Returns to Scale
 It is possible for a production function to
exhibit constant returns to scale for some
levels of input usage and increasing or
decreasing returns for other levels
 economists refer to the degree of returns to
scale with the implicit notion that only a fairly
narrow range of variation in input usage and
the related level of output is being
considered
 Constant Returns to Scale
 Constant returns-to-scale production
functions have the useful theoretical
property that that the MRTS between
K and L depends only on the ratio of K
to L, not the scale of operation

 Geometrically, all of the isoquants are

“radial blowups” of the unit isoquant
 Constant Returns to Scale
 Along a ray from the origin (constant K/L),
the RTS will be the same on all isoquants
K per period

The isoquants are equally

spaced as output expands

q=3
q=2
q=1

L per period
 Returns to Scale
 Returns to scale can be generalized to a
production function with n inputs
q = f(X1,X2,…,Xn)
 If all inputs are multiplied by a positive
constant m, we have
f(mX1,mX2,…,mXn) = mkf(X1,X2,…,Xn)=mkq
 If k=1, we have constant returns to scale
 If k<1, we have decreasing returns to scale
 If k>1, we have increasing returns to scale
The Linear Production Function
 Suppose that the production function is
q = f(K,L) = aK + bL
 This production function exhibits constant
returns to scale
f(mK,mL) = amK + bmL = m(aK + bL) = mf(K,L)
 All isoquants are straight lines
 MRTS is constant
The Linear Production Function
Capital and labor are perfect substitutes

K per period
MRTS is constant as K/L changes

slope = -b/a

q1 q2 q3
L per period
 Fixed Proportions
No substitution between labor and capital
is possible
K per period K/L is fixed at b/a

q3/a q3

q2

q1

L per period
q3/b
 Cobb-Douglas Production
Function
 Suppose that the production function is
q = f(K,L) = AKaLb A,a,b > 0
 This production function can exhibit any
returns to scale
f(mK,mL) = A(mK)a(mL) b = Ama+b KaLb = ma+bf(K,L)
 if a + b = 1  constant returns to scale
 if a + b > 1  increasing returns to scale
 if a + b < 1  decreasing returns to scale
 Cobb-Douglas Production
Function
 Suppose that hamburgers are produced
according to the Cobb-Douglas function
q = 10K 0.5 L0.5
 Since a+b=1  constant returns to
scale
 The isoquant map can be derived
q = 50 = 10K 0.5 L0.5  KL = 25
q = 100 = 10K 0.5 L0.5  KL = 100
 The isoquants are rectangular hyperbolas
 Cobb-Douglas Production
Function
 The MRTS can easily be calculated
f L 5L0.5 K 0.5 K
MRTS ( L for K )   0.5 0.5 
f K 5L K L
 The MRTS declines as L rises and K falls
 The MRTS depends only on the ratio of K
and L